Trailing Stop-Loss Orders

A trailing stop loss is a type of forex order that makes use of an automatically-adjusted stop-loss limit instruction. A stop-loss enables you to set a threshold to prevent continuing losses by closing an order once the exchange rate reaches the level you specify. For example, if you are long USD/JPY at 109.88, you could set a stop loss at 107.00. If the exchange rate falls to this level, the order is closed by the trading system thereby limiting your losses.

A trailing stop loss is based on the same concept but it also protects potential earnings. It does this by automatically moving the stop-loss limit closer to the market price if the market price moves in your favour.

For instance, if you are long EUR/USD at 1.44625 and you want to limit your losses to no more than 20% of the original market price, you would set your initial stop loss at 1.20521. If the exchange rate for the EUR/USD currency pair were to rise in value to 1.88013 and you still wanted to maintain your 20% stop loss rule, you would have to manually change the stop loss threshold to 1.56677. However, with trailing sto- losses enabled, the trading platform automatically makes the adjustment for you. This ensures the profit you gained on the order can be realized while still providing protection against unacceptable losses. The approach used to set trailing stops may vary by trading system but will typically involve one or more of the following methods:

1. Percentage-based – as demonstrated above, allows for the establishment of a percentage variance for the stop loss

2. Pip-based – allows for the setting of trailing stops based on a certain number of pips

3. Price-based– allows for the setting of trailing stops based on a price range

Use Caution When Working With Trailing Stop-Loss Orders

Trailing stop-loss orders – just like regular stop-loss orders – must be used with caution. The irony with stop-loss instructions is that even though they are designed to protect you from extreme losses, using them carelessly can actually increase losses.

To illustrate how this can happen, refer back to the USD/JPY currency pair which you hold long at 109.88 – if you were to set the stop-limit at 109.55, a relatively slight drop in the exchange rate would trigger the sale of your order. When you think about it, a drop to 109.55 from 109.88 is really not much of a fluctuation and it is quite likely that this level could be reached in the normal ebb and flow of daily prices, thus triggering your stop-loss. This means that you will be sold out without any possibility of benefiting from a potential rally in the exchange rate thereby guaranteeing a loss.

Therefore, when setting a stop-loss limit, be careful not to set the limit so close to the spot rate that normal fluctuations trigger the limit order.